What Is a Net Operating Loss Deferred Tax Asset?

A net operating loss deferred tax asset is a future tax benefit that arises when a company experiences a financial loss. This benefit is recorded as an asset on the balance sheet, reflecting the expectation that past losses can lower tax payments in future profitable years. The existence of a deferred tax asset signals that a company has endured unprofitability, but it also represents potential for improved future cash flow. The value of this asset is tied to the company’s ability to generate sufficient future income to use these losses.

The Creation of a Net Operating Loss DTA

A net operating loss (NOL) occurs when a company’s tax-deductible expenses surpass its taxable revenues within a specific period, resulting in no income tax liability for that year. Instead of being lost, tax laws permit the company to carry the loss forward to offset taxable income in later, profitable years. This carryforward provision gives rise to a deferred tax asset (DTA), the value of which is calculated by multiplying the total NOL by the applicable corporate tax rate.

For instance, if a company reports an NOL of $2 million and the corporate tax rate is 21%, it can recognize a deferred tax asset of $420,000. This figure represents the future tax savings the company can realize by applying its past loss against future profits, and this value is recorded on the balance sheet.

Tax laws dictate the periods over which these losses can be carried forward. Under the Tax Cuts and Jobs Act (TCJA), NOLs arising in tax years after 2017 can be carried forward indefinitely. However, the annual deduction is limited to 80% of taxable income for that year.

Accounting and Financial Statement Presentation

Recognizing an NOL deferred tax asset is a formal process governed by Accounting Standards Codification 740. When a company has an NOL to carry forward, it records a journal entry to create the DTA. This entry involves a debit to the Deferred Tax Asset account and a credit to the Income Tax Expense (or Benefit) account.

The debit to the Deferred Tax Asset account increases the assets on the company’s balance sheet. All deferred tax assets are classified as non-current assets, reflecting the long-term nature of the expected benefit as it will be realized over future periods.

The credit side of the journal entry has a direct impact on the income statement. By crediting Income Tax Expense, the company records an income tax benefit, which reduces the overall net loss for the period. This can seem counterintuitive, as the company is reporting a loss but also a tax benefit. This accounting treatment is designed to match the tax effects of the NOL with the period in which the loss occurred.

On the balance sheet, the DTA is presented as a non-current amount, often netted against any deferred tax liabilities (DTLs) from the same tax jurisdiction. The footnotes to the financial statements provide detail about the DTA’s composition, including the total NOL carryforwards and any associated valuation allowances.

The Valuation Allowance

A valuation allowance is a contra-asset account that reduces a deferred tax asset’s carrying value to the amount realistically expected to be realized. Companies must assess the realizability of their DTAs each reporting period. A valuation allowance is required if it is “more likely than not”—a greater than 50% probability—that some or all of the DTA will not be realized, an assessment based on all available positive and negative evidence.

Negative evidence includes a history of recent losses, projections of future losses, or the expiration of NOL carryforwards in the near future. A consistent pattern of unprofitability is a strong indicator that the company may not generate sufficient taxable income to use its DTAs.

Conversely, positive evidence can support not needing a valuation allowance. This could include a history of strong earnings, existing contracts that ensure future profitability, or a credible business plan for recovery. The weight of all evidence determines the appropriate level of the allowance.

When a valuation allowance is recorded, it increases the income tax expense for the period, reducing net income or increasing a net loss. If a company’s financial outlook improves, it may release some or all of the allowance. This release decreases the income tax expense and increases net income.

Limitations on NOL Utilization

External rules can also restrict a company’s ability to use its NOLs, separate from the valuation allowance assessment. A primary limitation is imposed by Section 382 of the Internal Revenue Code following a change in corporate ownership.

An “ownership change” is generally defined as a shift of more than 50 percentage points in the value of a company’s stock owned by 5% shareholders over a three-year period. When such a change occurs, the annual amount of pre-change NOLs that the company can use to offset future taxable income is restricted. This rule is designed to prevent companies from being acquired solely for their tax losses.

The annual limitation is calculated by multiplying the fair market value of the company’s stock immediately before the ownership change by the long-term tax-exempt rate, which is published monthly by the IRS. For example, if a company with a market value of $10 million undergoes an ownership change and the applicable rate is 2%, its annual NOL utilization would be capped at $200,000.

This limitation does not eliminate the NOLs but spreads their use over a longer period, and any unused annual limit can be carried forward to subsequent years. This limitation can impact the DTA’s value and may require a valuation allowance if it becomes likely the NOLs will expire unused due to the annual cap.